Stopping corporate tax avoidance in a house of smoke and mirrors

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Pat McConnell does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

A Senate inquiry on corporate tax avoidance this week will hear of the strange corporate structures used by companies such as News Corp, Google and Apple to euphemistically “optimise” their tax affairs. The companies and their tax advisers baulk at even the mention of the words “tax avoidance”.

However, while seemingly the optimisation tool of choice for News Corp and our big mining companies, the tax avoidance trick of setting up a shell company in an idyllic island or small European country and passing assets and income across its books is pretty old hat. Tax advisers today are using complex derivatives to massage money so that minimum, even better no, taxes have to be paid. These tax avoidance schemes involve not a hole in the wall in Luxembourg, but the very latest in financial engineering.

Taxation is a subject that makes even experts’ eyes glaze over. Likewise, financial derivatives get very technical, very quickly. Put the two together and you have the makings of a very short-lived conversation. But it is a conversation that tax advisers love to have with their rich corporate clients, including large banks.

Derivatives are basically financial alchemy. If one has some money, or is about to come into some money, bankers will, for a nice fee, organise the flow of that money so that it precisely suits your needs, and if you manage to save a bit of tax in the process - so much the better.

One particular trick used by among others, Mitt Romney, is called a Total Return Swap (TRS). This particular magic wand is able to turn taxable dividends into capital gains taxed at a much lower level.

So how does tax come into the derivatives picture?

Close to home

One example of how such swaps are used is by our very own Future Fund, which has somehow managed to escape the gaze of Senators this week.

In a transaction involved in purchasing “distressed debt”, profits magically would be moved through a TRS from Luxembourg (a low taxing country) to the Cayman Islands (a no taxing country). Needless to say, Future Fund managing director David Neal was aghast that anyone would even suggest that such a complicated transaction was done to avoid tax. The Future Fund is now liable to pay income tax in Australia, but is subject to tax on profits in some foreign countries.

Banks and hedge funds are at the centre of this new alchemy, finding magical ways to turn income into capital gains or even better into expenses or tax losses.

How is it done?

It’s fiendishly complex (otherwise everyone would be doing it) but one way involves moving loans, guarantees and Interest Rate Swaps (of various types) between international companies in a spider’s web of cash payments, such that everyone wins but the tax authorities.

This is precisely what the Big Four Australian banks were found to have done when they settled with the New Zealand Inland Revenue Department (IRD) in December 2009 after being found guilty of creating “tax avoidance arrangements entered into for a purpose of avoiding tax”. This settlement of some A$1.7 billion was the largest legal settlement in Australian banking history. The irony of being found to have avoided paying taxes to the same taxpayers who had just guaranteed their safety in the global financial crisis appears to have been lost on the boards of Australian banks.

Much of the debate in the Senate Committee this week will deal quite rightly with shuffling of money between offshore tax havens or on company restructuring to minimise tax, but the future of tax avoidance is already out there and it’s not tax havens – it’s financial sorcery.

Dealing with complexity

More and smarter taxmen (and women) will be needed to deal with this complexity in future, at a time when the government is decimating their ranks at the Australian Taxation Office. Ironically, ATO staff are being replaced in some cases by external consultants, such as, you guessed it, PWC - yes the same PWC that thought up the Luxembourg schemes.

The European Union has recently enacted legislation curtailing the activities of audit firms with regard to tax advice. Australian Senators should consider similar legislation.

Pat will be on hand for an Author Q&A session between 10 and 11am AEST on Thursday April 9. Post your questions about the article in the comments section below.